Rio simply can't afford to sit on its assets

Rio Tinto's first loss was broadly welcomed by investors hoping to see an end to the bad news and pleased by the higher-than-expected dividend.

But the morning after Thursday's result for last year brought more sober analyses of the challenge facing the new chief executive, Sam Walsh, given Rio's overwhelming reliance on its Pilbara iron ore mines in Western Australia.

According to Commonwealth Bank analysts, the Pilbara delivered 104 per cent of Rio's earnings before interest and tax (EBIT) last year - which says nothing else mattered, and nearly everything else was effectively a drag on earnings, even in a year when the company's realised iron ore prices from Australia dropped 20 per cent.

Iron ore has staged a dramatic recovery from below $US90 a tonne to above $US150 a tonne, and is holding up for now. Accordingly, Rio shares have run strongly since the end of August, rising 45 per cent despite the turmoil last month that included the announcement of $US14 billion in write-downs, the dumping of the former chief Tom Albanese, and his being replaced by Walsh, the former iron ore chief.

Rio's shares pulled back on Friday as the market digested the numbers and Walsh's single message on the earnings call: pursuing greater value for shareholders.

But CBA's Andrew Hines said last year's figures underlined the scale of the challenge for Rio: the imbalances in its asset base and the ''plummeting'' return on invested capital last year to just 7.9 per cent.

As the accompanying table shows, CBA analysts class only four of Rio's assets as ''tier one'' - meaning they achieve a return on capital above 15 per cent, they have more than 10 years to run, and they account for more than 5 per cent of group EBIT. Those assets are iron ore in Australia, iron ore in Canada, the Kennecott Utah copper mine, and a 30 per cent stake in the huge Escondida copper mine in Chile, majority-owned by BHP Billiton.

Those four assets represent just 37 per cent of Rio's total asset base, but contributed 126 per cent of its EBIT last year.

Put another way, two-thirds of Rio's assets - including coal and uranium, and the up-for-sale aluminium and diamonds businesses - subtracted 26 per cent from group earnings.

CBA has compared Rio to the BHP of the mid-to-late '90s. After years of poor acquisitions and loose capital investment decisions, the market had lost sight of the quality of BHP's underlying asset base.

As Hines wrote last month: ''The template for what Rio needs to do next already exists - in our view, Rio should follow the example set by Paul Anderson and Chip Goodyear when they cleaned up BHP.''

On that view, the other two-thirds of Rio's assets need to be improved, closed or sold. It's a massive transformation.

A case study is Rio's coal business in Queensland and NSW - by rights, a tier one asset. Between 2008 and last year, CBA notes, revenue fell 3 per cent, with a 10 per cent increase in production offset by an 11 per cent decline in price; net profit fell 77 per cent; expenses increased 77 per cent; and return on capital dropped from 239 per cent to 11 per cent.

JPMorgan's Lyndon Fagan says Rio delivered a ''solid result''. He marginally raised his earnings forecast for this year and next.

Fagan welcomed confirmation from Walsh that further mergers and acquisitions were ''not on the radar'' and expected "significant cash proceeds" from an expanded list of non-core asset sales.

In the London earnings call, the soon-to-depart finance chief, Guy Elliott, confirmed: ''We are looking at further disposals than the ones that we've announced.''

Fagan said Walsh's overall message was ''what the market wanted to hear''.

Citi's Clarke Wilkins wrote that Rio was ''regaining the mojo'' it lost in the aftermath of the disastrous acquisitions of Alcan ($US38 billion, 2007) and Riversdale Mining ($US3.9 billion, 2011).

''We expect Rio to regain the swagger in 2013,'' wrote Wilkins, helped by the high iron ore price.

''To do this, we think Rio needs to deliver on the fast-tracked Pilbara iron ore projects and reduction in costs to increase cash flow. If this is combined with assets sales, it should put the company in a position to return excess cash to shareholders in 2014 through dividend increases and capital management.''

Citi expects BHP, which delivers its interim result on Thursday, to deliver underlying earnings for the first half of 2012-13 of $US6 billion, down 40 per cent on the $US10 billion reported a year ago, because of lower iron ore, copper, aluminium and coal prices and the stronger dollar.

After taking a $US2.8 billion write-down against its US shale acquisitions in August, BHP should present a much cleaner set of figures next week.